Transcript A2 Accounts

Investment Appraisal
Techniques
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Investment Appraisal
What do you understand by the term
Investment Appraisal?
Investment appraisal involves a series of
techniques, which enable a business to
financially appraise investment projects.
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Investment Appraisal
It is a techniques use to determine if a
particular investment is worthwhile.
It can be used to compare different projects
to determine which is more favourable.
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Types of Investment Appraisal
Techniques?
Pay Back Period (PBP)
Accounting Rate of Return (ARR)
Net Present Value (NPV)
Internal Rate of Return (IRR
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Pay Back Period
This is defined by CIMA as 'The time required for the
cash inflows from a capital investment project to
equal the initial cash outflow(s)
It simply means the time it takes an investment to
pay back the amount invested.
The decision rule is that projects with the minimum
pay back time are acceptable.
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Disadvantages of the payback
method

It ignores the timing of cash flows within the payback
period.

It also ignores the cash flows after the end of the payback
period and therefore the total project return.

It ignores the time value of money. This means that it does
not take account of the fact that £1 today is worth more
than £1 in one year's time.

The method is unable to distinguish between projects with
the same payback period.

It may lead to excessive investment in short-term projects.
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Advantages of the payback
method

Payback is an easily understood concept.

The calculation is quick and simple

Shorter-term forecasts are likely to be more reliable.

It is a measurement of Investment risk as risk is
increased if payback is longer.
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Practice Question
Calculate the PBP for the two projects.
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Accounting Rate of Return (ARR)
Accounting Rate of Return (ARR) expresses the
average accounting profit as a percentage of the
capital outlay.
The decision rule is that projects with an ARR
above a defined minimum are acceptable; the
greater the ARR, the more desirable the project.
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Calculating the accounting rate of return
The average investment is calculated as :
(Initial investment + final or scrap value)
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Practice Questions
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Disadvantages

It is based on accounting profits rather than cash flows,
which are subject to a number of different accounting
policies.

It is a relative measure rather than an absolute measure
and hence takes no account of the size of the investment.

It takes no account of the length of the project.

Like the payback method, it ignores the time value of
money
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Advantages

It is quick and simple to calculate.

It involves a familiar concept of a percentage return.

Accounting profits can be easily calculated from financial
statements.

It looks at the entire project life
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Net Present Value (NPV)
This takes into account the time value of money. It
is based on the principle that money is worth
more than it is in the future. The principle exists
for two reasons:

Risk – money in the future is uncertain.

Opportunity cost –could be in an interest account
earning interest.
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Net Present Value (NPV)
NPV = present value of cash inflows minus
present value of cash outflows.
NPV=PVCI-PVCO

If the NPV is positive, it means that the cash inflows from a project
will yield a return in excess of the cost of capital, and so the project
should be undertaken.

If the NPV is negative, it means that the cash inflows from a project
will yield a return below the cost of capital, and so the project should
not be undertaken.

If the NPV is exactly zero, the cash inflows from a project will yield a
return which is exactly the same as the cost of capital.
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Advantages

Considers the time value of money.

It considers all relevant cash flows, so that it is unaffected
by the accounting policies which affects profit-based
investment appraisal techniques such as ARR

Reducing discounting rate reduces future monies more
heavily.

Only one method that gives a definitive answer.

Positive return – it is worth doing
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Disadvantages

Time consuming.

More difficult to understand.

Based on an arbitrary choice of interest rate.
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Practice Questions
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Internal Rate of Return (IRR)

This is a technique that equates the PV of the
cash out flow with the PV of the cash in flow.

The IRR of a project or investment is the
discount rate that results in an NPV of zero.
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Internal Rate of Return (IRR)
Where:
A is the (lower) rate of return with a positive NPV
B is the (higher) rate of return with a negative NPV
P is the value of the positive NPV
N is the absolute value of the negative NPV
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Practice Questions
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Advantages

The main advantage is that the information it provides is
more easily understood by managers, especially nonfinancial managers.

A discount rate does not have to be specified before the
IRR can be calculated. A hurdle discount rate is simply
required which is then compared with the IRR.
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Disadvantages

If managers were given information about both ARR and
IRR, it might be easy to get their relative meaning and
significance mixed up.

It ignores the relative size of investments.
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Exercise 1
Evaluate the 3 Projects using PBP, ARR and NPV and offer appropriate
advice.
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